The coming (market) regime change

At the start of the year, I wrote that the biggest risk for markets in 2026 was not earnings; rather, it was the earnings multiple:

Predicting earnings isn’t the hard part. Predicting the multiple on those earnings is.

That’s because the earnings multiple is all about sentiment. When investors are bullish and the outlook is strong, markets will trade on higher multiples. It’s only when uncertainty creeps in that multiples begin to contract.

Markets are inherently uncertain. When earnings multiples (whether for markets in general or stock-specific) are high, it indicates that investors aren’t fully pricing in this uncertainty. Rather, they’re putting a premium on certainty!

This makes me nervous. I don’t want to be buying in that environment. It might feel safe, but it’s not.

It’s fair to say that investor sentiment is not as positive as it was at the start of the year.

Wars can do that.

And this war will likely be the catalyst for a ‘regime change’ in investor sentiment.

In this wire, I’ll explain why…and what it means for portfolio construction.

Investor sentiment is all about the perception of certainty.

When investors feel confident about the future, they are willing to pay a high price for earnings. After all, those earnings are ‘certain’.

Just a few months ago, investors were certain about the growth trajectory of many SaaS (software-as-a-service) companies. The sky was clear. Earnings growth was robust as far as the eye could see.

As a result, investors applied eye-watering multiples to these businesses.

They are now in the long, slow process of experiencing ‘multiple compression’, in which investors reassess their prospects. There is a little more uncertainty about growth prospects these days. Investors can't see so far ahead anymore.

At the same time, certainty around AI and the riches it will bring is changing too. Big tech companies are committing hundreds of billions of dollars to investments that have unknown future return profiles.

This massive infrastructure investment is absorbing previously plentiful free cash flows and many more billions in Wall Street liquidity, via corporate debt and private credit raisings.

In the next few years, assuming all this goes ahead, the ‘hyperscalers’ will transform from capital-lite free cashflow generators to capital-intensive AI infrastructure plays, with unknown ongoing investment requirements.

Alongside this buildout, you need massive investment in the energy grid to power the data centres. Again, liquid capital from Wall Street will transform into long-term energy assets in the years to come.

Liquidity is the issue

This liquidity withdrawal from financial markets into the real economy is already manifesting in stalling share price appreciation.

The NASDAQ, the leader in this long, tech-driven bull market, topped out in late October last year. The S&P500 pushed on for a few more months, reaching a high in late January.

But the financials sub-index is breaking down, led by losses in the private equity and private credit giants like Blackstone and KKR.

Notably, Blackrock’s share price plunged more than 7% on Friday. It was the worst performer in the financials index, after Bloomberg reported it had market a private credit loan to zero just a few months after assessing it at 100 cents on the dollar.

That’s worth taking note of.

Against this backdrop, where a certain amount of caution was starting to creep in, you have a renewed war in the Middle East, with energy prices surging.

To state the obvious, this results in a huge increase in uncertainty.

Making predictions about war is all but useless. And you risk looking foolish in a couple of weeks if you do so.

Absent a quick transition to a friendly regime in Iran, which is a low-probability outcome at this stage, it’s fair to say that oil prices will remain elevated.

How far they could go in the short term is anyone’s guess. Iran’s attacks on energy infrastructure in the region could see prices move higher than anyone expects.

A lesson from past conflicts is that oil prices spike initially and then ease. So while we could be close to an oil price peak within the next few weeks, the important consideration is, where do oil prices settle in the longer term?

I don’t know. But it’s unlikely to be where they were before the conflict started. My guess is somewhere in the US$80 a barrel range, as a reasonable energy security premium is priced in.

Another thing to consider with oil is its impact on market liquidity. The oil and gas market is huge, with a value running in the trillions of dollars. When oil and gas prices spike, they absorb a significant amount of market liquidity.

This liquidity will be sucked out of other sectors, manifesting in lower multiples and prices.

In short, we’re experiencing a market regime change. This change started very quietly last year and will continue throughout 2026. These changes are a process, not a moment.

As an investor, it’s important you focus on the potential road ahead, rather than drive while looking in the rear-view mirror.

Buying fallen favourites in the hope or expectation that they will bounce back to former highs may be a flawed strategy. Investors are unlikely to pay sky-high multiples for future growth in a more uncertain environment.

Valuation discipline will be key, as implied discount rates are likely to rise in this new regime.

Consider that the yield on Aussie 10-year bonds – the supposed risk-free rate – is around 4.95%. The forward PE on the ASX200 is somewhere around 18-20 times, depending on the forecast. That translates into an earnings yield of 5.55% - 5%.

In other words, there isn’t much of an equity risk premium priced into the Aussie market right now. Which is a worry.

The last time bond yields were this high was in October 2023, when the ASX200 was 20% lower than where it is now.

That tells me this regime shift, this change in investor sentiment, could still be in its early phases.

What does this mean for portfolio construction?

In general, it means you should probably hold higher cash levels than usual and have more defensive exposures. Know what you own and why you own it. In a market losing liquidity, having liquidity (cash) to take advantage of panic sell-offs is very valuable.

Is it too late to jump into energy?

In the short-term, yes. But energy is likely to trade with a strategic premium in the future, as countries put a higher price on energy security and hold more inventory than usual. Given that energy companies were out of favour leading into this crisis, it’s likely that investors will now buy on weakness.

And there are no coal fields in the Middle East, which is bullish for coal producers. There will be a premium on reliability too. 

The portfolio I run had 20% cash and over 25% energy exposure leading into this crisis. That wasn’t based on expecting a Middle East war. It simply reflected prior good value amongst oil, gas and coal stocks, and stretched valuations elsewhere

While that has provided a solid defensive element for the portfolio, I’m now grappling with how best to manage it.

Reduce energy exposure into this panic spike and rotate into other sold-off sectors? Reduce and increase cash even further on the basis that this market regime change is in its early stages?

Or, do nothing for now?

While it’s not a bad problem to have, it does highlight we’re at a very tricky stage for financial markets.

Tech and the AI boom were already showing signs of running out of puff before the Middle East blew up. Now surging energy prices are sucking more liquidity from a fragile market.

Maybe this isn’t a simple case of buying the dip.

If this is a regime change, it's time to be cautious rather than gung-ho.

As I wrote back in January:

As we head into 2026, I think investors are too willing to pay a high price for comfort and certainty.

In this business, you get paid for taking on discomfort and uncertainty.

There could be plenty of discomfort and uncertainty coming our way this year. That's great for future returns, but survival is the key. 

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